Fiscal Rules and the Sovereign Default Premium

We use a sovereign default model to study the effects of introducing fiscal rules. A debt-brake (spread-brake) rule imposes a ceiling on the government budget balance with the objective of upholding sovereign debt (spread)... [ view full abstract ]

We use a sovereign default model to study the effects of introducing fiscal rules. A debt-brake (spread-brake) rule imposes a ceiling on the government budget balance with the objective of upholding sovereign debt (spread) levels below a threshold. For a single model economy, similar welfare gains can be achieved with either a debt brake or a spread brake. However, for sets of heterogeneous economies, a common spread brake generates larger welfare gains than a common debt brake. This suggests that when political constraints force common fiscal targets across economies, a common spread brake may be preferable over a common debt brake. Even if we could tailor fiscal rules to a single economy, a spread brake would be a better option when there is uncertainty about key characteristics of this economy and these characteristics may change over time. Furthermore, it could be easier to enforce a spread brake than to enforce a debt brake.